Efficient earmarking under decentralized fiscal commitments

Source: OECD Fiscal Decentralization database.

This is clearly explained in Oates (2005), which provides an excellent review of the fiscal federalism literature. It includes an overview of the traditional viewpoints that emerged from the first-generation theory of fiscal federalism and the new viewpoints that have been emerging with the second-generation theory of fiscal federalism. The literature that studies the incentives that create soft budget constraints is one of the branches that advance new thinking on fiscal federalism.

Lotz (2013) also makes a similar observation based on cost-efficiency terms.

The analysis here assumes complete information and does not consider political economy issues. Furthermore, the model assumes that regional public goods do not produce interregional spillovers. Hence, earmarked grants cannot possibly be justified in terms of Pigouvian correction incentives.

See also Buettner and Wildasin (2006). In addition, Wildasin (1997) discusses the bailout cases in New York, Philadelphia and São Paulo, among others, and Rodden et al. (2003) discusses bailout cases in Latin America.

It is straightforward to show that the subgame perfect equilibrium for the sequential game in which the center is the Stackelberg leader and the regional governments are the Stackelberg followers is isomorphic to the simultaneous Nash equilibrium considered in the text.

As correctly pointed out by a reviewer, the redistributive constraints (4e) and (4f) are a particular case of a federal redistributive grant system in which the federal government faces the following constraint on federal grants: \({\sum \nolimits _{j=1}^{J}} {s_{c,j} } ={\sum \nolimits _{j=1}^{J}} {{\sum \nolimits _{l=1}^{L}} {s_{l,j} } } \). Under this federal system, the federal government would have the ability to allocate dollars across all programs (private consumption and public consumption) that are controlled by the federal government for equalization purposes. We rule out this grandiose federal system in the analysis for the following two reasons: (i) the grandiose system implies that the federal government is ultimately able to not only equalize expenditure levels per program but also determine the level of final expenditures in each program; and (ii) the restrictive system implied by conditions (4e) and (4f) is the one in which the federal government plays the most limited role in inducing the regional governments to behave efficiently.

In principle, different regional governments may have different abilities to commit to provision of regional public goods. It is, therefore, possible that some regional governments are able to commit more credibly to the provision of some public goods than some other regional governments. For simplicity and to keep the model as symmetric as possible, the case examined in this paper is restricted to a situation in which all regional governments face the same constraint on the ability of making credible commitments.